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An Investor’s Quick Checklist for Banks – Part 1

Singapore – which has the banking trio of DBS Group Holdings (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39), and United Overseas Bank (SGX: U11) – is home to some of the largest banks in the South East Asia region.

With the investment arm of Singapore’s government as its largest shareholder, DBS counts itself as the largest bank by assets in SEA and has operations in more than 15 different markets.

Meanwhile, OCBC, which is majority owned by the Lee Foundation of Singapore, has been named as the World’s Strongest Bank by Bloomberg Markets in 2011 and 2012. It is also the major shareholder of the largest national insurer, Great Eastern Holdings (SGX: G07).

Last but not least, UOB is the leader for the credit card and personal home loan businesses in Singapore. It’s majority owned by the Wee family, whose other business interests include United Overseas Land (SGX: U14), Haw Par Corp (SGX: H02) and UOB Kay Hian (SGX: U10)

How banks make money?

With such strong banks in Singapore, it’s perhaps fitting to ask:  How exactly does a bank earn a profit?

The fundamental business model of a bank is to earn interest income. When we deposit our cash into a bank, it might be paying us an interest of say 1% on our deposits. At the same time, the bank would turn around  and use the cash it has collected from our deposits to loan it out to an individual or organisation and charge a higher interest rate of say, 3%. This will allow the bank to earn a spread of 2% (3% minus 1%) between the interest it is collecting and the interest it is paying out.

Increasingly, banks are turning to non-interest income as interest rates remain extremely low in the current environment. Non-interest income typically includes transaction fees, management fees or even inactivity fees.

Top three risks

Generally, banks need to manage three types of risks well and they are: 1) Credit risk; 2) Liquidity risk and; 3) interest rate risk.If a bank is able to control the trio of risks better than its competitors, it can be a mark of a high quality bank.

Credit risk control is an essential part of a banking business; we have seen how undisciplined credit control among banks had led to the global financial crisis half a decade ago. We can get a rough idea of how a bank is controlling its credit risks from looking at its balance sheet, loan breakdown and the trend in its non-performing loans and bad debt write-offs.

Liquidity is very important to a lender, as one of the worst things that can happen to a bank is to be forced to sell some assets to improve its liquidity. Therefore, it’s important to examine a bank’s loan to deposit ratio and capital ratios to ensure it is not over-leveraging itself.

As hard as it is for banks to admit, they are not in control of the interest rate environment. As such, the spread that it can earn on the interest it is paying out and the interest it is collecting is also not entirely within its control; this thus introduces interest rate risk into a bank’s operation.

One indicator we could look at regarding interest rate risk is the net interest margins (NIM) of a bank, which can be simply understood as the aforementioned ‘spread’. When we compare changes in a bank’s NIM in different interest rate environments, we can get a sense of which bank is able to mitigate interest rate risk more effectively.

Foolish summary

Banks play a major role in any country’s economy and are often the main source of credit for other industries. By understanding banks, we not only get a sense of how the banking industry is doing, we will also get to see how the banks can influence the development of the economy as a whole. I’ll be diving more into banks soon, so stay tuned!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.